the laffer curve depicts the relationship between tax rate and tax revenue. when there is a high tax rate, little tax revenue is made. the shape of the curve shows that as tax rate decreases, tax revenue increases (until the maximum point) and the GDP grows.

LOOK AT TEST FOR DRAWING

why is inflation bad?

(1)

menu cost

misallocation of resources:

P-AC is low = efficiency (price - average cost)

lower price does not necessarily mean lower average cost?

explain why reduction in tax can lead to an increase in government revenue

lowering taxes promotes a stronger incentive to work and produce by increasing after-tax prices and wages, according to supply-side economic policy. this increases production, which leads to taxable income. the laffer curve depicts the fact that as taxes are reduced, government revenue increases inversely.

why is inflation bad? (2)

inflation-induced tax distortions:

Example: in 1980, you invest $10 in stock. in 2008, stock price goes up to $50 = revenue of $40.

if price doubles, $10 is now worth $20 ad $50 stays the same = revenue of $30 ...in this case you are overtaxed and will discourage savings

why is inflation bad? (3)

arbitrary distribution of wealth: has a lot to do with borrower and lender --borrower benefits from inflation

hyperinflation

occurs when a country is experiencing a very high and unusually accelerating rate of inflation -- prices increase and currency value decreases

there was hyperinflation

in post-World War I in Germany

stagflation

a situation where inflation rate is high but the economy slows down (and the unemployment remains steadily high)

international economics

some sectors are more dependent on international trade than small ratio suggest: such as agriculture, aircraft manufacturers, etc.

impact on US of other international economic connections:

US subsidies abroad

financial systems

balance of payments

all transactions that take place between the US and the rest of the world

-the balance of payments always has to balance

**an itemized account of a nation's foreign economic transactions

marginal propensity to import

if MPM>0, any increase in income will lead to an increase in imports (relates to income effect)

the price of money is interest rate. so it interest rate increases, investment decreases. less goods are bought which will result in less production and sales, leading to recession because of inflation. this causes imports to decline further.

US turns protectionist through the Smoot-Hawley Tariff of 1930 - this provoked retaliation

Europe abandons gold standard

adoption of exchange and other trade controls; most currencies became "inconvertible"

bretton woods system

Governments agree to fix the value of their currency on US dollars and US dollars is fixed on the value of the gold.

bretton woods system

the institutions emerged from the conference: International Monetary Fund (IMF); the International Bank for Reconstruction and Development (World Bank) and GATT (now WTO)

international monetary fund (IMF)

purpose was to achieve world-wide currency convertibility

reasonable exchange rate stability

combine reasonable exchange rate stability with national independence in monetary and fiscal policies

rules of IMF

contribution based on relative size of economy and share in world trade

25% of quota paid in US dollars or gold and remainder in national currency

each member can borrow up to 1.25 times quota

each country declares exchange rate relative to dollar and/or gold

major devaluations needed IMF approval

the smithsonian agreement of 1971

dollar went off gold, so gold became a commodity. gradual introduction of flexible exchange rates of major industrial countries.

under the gold standard, explain what it means by "sacrifice internal equilibrium to achieve external equilibrium"

under the gold standard, internal equilibrium must be sacrificed to achieve external equilibrium. this means that when a country is in a deficit, the money supply decreases. by the quantity theory of money (MV=PQ), when money supply decreases, the general price decreases as well. If the price decreases, then interest rate increases and investment and consumption decreases as well. There is lower production and sales, and so the economy will fall into recession. The economy will then use the gold standard to repair the equilibrium.

under the gold standard, explain why it is not possible for currency to appreciate or depreciate.

the currency is backed by gold. the currency has a set exchange rate that cannot be altered because gold is a commodity that does not have an endless supply.

the plaza agreement of 1985

The objective of this agreement was to depreciate the US dollar in relation to the Japanese Yen and German Deutshce Mark by intervening in the currency markets. The reason for the depreciation was to reduce the US current account deficit which had reached 3.5% of the GDP and to help the US economy emerge from a deep recession. By devaluing the dollar, US exports rose. The agreement was successful in reducing trade deficit with Europe; however, it did not alleviate the trade deficit with Japan. US goods were more competitive but were unable to succeed in the Japanese market.

trade deficit

when the imports of a country are greater than exports

trade surplus

when the exports of a country are greater than imports

when a country has a trade surplus, gold flows in and people exchange gold for currency. money supply increases, so price increases, which leads to inflation. export less, import more, interest rate will decrease so investment increases, and GDP rises. this leads to more imports and a decrease in the trade surplus.

gold standard: the government guarantees to trade the national currency for gold at a fixed rate

fixed exchange rate (2)

1. gold standard: the government guarantees to trade the national currency for gold at a fixed rate

---it is not possible for gold to appreciate or depreciate under G.S. because the currency is backed by gold. the currency has a set exchange rate that cannot be tampered with because gold is a commodity that does not have an endless supply

fixed exchange rate (3)

2. pegged exchange rate: exchange rate fixed by government

pegged exchange rate

the exchange rate is fixed by the government

shifters of the curve

tastes

price level

income

interest rates -- when the interest rate is higher in one country, foreign investment will increase as foreigners seek higher revenues

appreciation

an increase in the value of one country's currency relative to another currency

when the USD appreciates, US goods become

more expensive relative to foreign goods, which makes exports fall and imports rise

if the central bank wants to devalue its currency under fixed exchange rate,

money supply increases in domestic market and output increases

what would tend to shift the supply curve of dollars in foreign currency exchange market to the right?

the expected rate of return on US assets falls

absolute advantage

a country's ability to produce a good costing fewer resources than another producer

OR

given a certain amount of resources the country can produce more of one good

absolute advantage (2)

John: 100 tables and 200 chairs

Mary: 200 tables and 100 chairs

John has AA in terms of producing chairs and Mary in tables

comparative advantage

a country's ability to produce at a lower opportunity cost than the country with which it trades

prices keep increasing because wage contracts are indexed by inflation. That way when price increases, wages must also increase making the cost to produce to increase and prices should increase again in response to higher cost. Since the wages will increase, the process is going to repeat all over again infinitely.

balance on current account

a category that itemizes a nation's imports and exports of goods and services, income receipts and payments on investment, and unilateral transfers.

unilateral transfers

transfers of currency made by individuals, businesses, or government of one nation to individuals, businesses, or governments in other nations, with no designated return.

balance on capital account

A category that itemizes changes in the foreign asset holdings of a nation and that nation's asset holdings abroad.

balance of trade

the difference between the value of a nation’s merchandise exported and imported.

balance of payment

an itemized account of a nation’s foreign economic transactions.

foreign exchange market

A market in which currencies of different nations are bought and sold.

exchange rate

The number of units of foreign currency that can be purchased with one unit of domestic currency.

appreciation

Increase in the value of one currency in terms of another.

depreciation

Decrease in the value of one currency in terms of another.

internal equilibrium

full employment with price stability (low inflation)

external equilibrium

balance of payments equilibrium (i.e., no need for loans to equilibrate the balance of payments)

foreign reserves

foreign currency held by some country's central bank

general agreements on tariffs and trade

The main objective was the reduction of barriers to international trade. This was achieved through the reduction of tariff barriers, quantitative restrictions and subsidies on trade through a series of agreements. The GATT was replaced by the World Trade Organization (WTO) in 1995

gold standard

The government guarantees to trade the national currency for gold at a fixed rate.

arguments in favor of tariffs

protect high paid jobs from cheap foreign labor

employment (raising tariff keeps foreign goods out)

defense

infant-industry

non-tariff barriers to trade

quotas

customs bureaucracy

government procurement

marketing barriers; labeling requirements

health restrictions

main instruments of protectionist policies

Tariffs: taxes on imported goods (for a long time were the main source of revenue for governments).

if a company exports a product at a price lower than the price it normally charges on its own home market, it is said to be “dumping” the product.

unconditional most favored nation principle

if a country and one of its trading partners agree to reduce a tariff, this tariff is reduced to all unconditional most favored nations.

(Members of GATT were all unconditional most favored nations of each other)

lorenz curve

shows the relationship between the cumulative population in a centain country (from the poorest to the richest) and the share of income which one hold.

gini coefficient

A common measure of the degree of concentration of wealth or income

vicious cycle of poverty

If the income per capita is low in one economy, then people tend to save less. This will lead to low investment and therefore, low productivity. Low productivity will in turn cause low economic growth, thus low income per capita.

disguised unemployment

the portion of the labor force that has marginal productivity (aka, marginal product of labor) equal to zero.

disguised unemployment (2)

it is more productive if we can reallocate the disguised workers to other sectors to other sectors

marginal productivity

the extra output an extra worker contributes to the total output.

import substitution industrialization

industrialization by producing the manufactured goods that are imported.

GDP

important indicator of economic performance

measures everything except that which is worthwhile

GDP per capita

shows the average productivity of the population

gini coefficient

measures the gap between the richest and poorest members of society on a scale of 0 to 1

measures income distribution

value of 0: expresses total equality

value of 1: expresses maximal inequality

the lorenz curve

shows the relationship between the cumulative population in a certain country and the share of income which one holds

the lorenz curve

terms of trade

the price ratio between the goods you sport and the goods you import aka

price of exports

price of imports

Raul Prebisch

terms of trade is declining overtime for LDCs, (least developing countries) thus poor counties become poorer because they are exporting food or raw materials. rich countries are exporting industrial goods.

Prebisch (2)

argues that the price of primary commodities declines relative to the price of manufactured goods over the long term, which causes terms of trade of primary-product based economies to deteriorate

export prices decrease for underdeveloped countries because of small demand growth and large supply growth. this results in engel's law (low income elasticity for demand of food). the small increase for demand is caused by technological advancement. increase in supply is due to labor supply growth.

demand from rich countries does not increase a lot because of the technological progress and synthetics, but poor countries keep increasing their exports to gain more wealth. the price decreases for the exporting goods.

industrial goods market

monopoly power of firms in developed countries and their unions prevented the prices of industrialized goods from dropping. therefore, terms of trade of poor countries is declining over time. this implies that poor countries don't gain wealth through free trade and these countries will stay in poverty.